Blending Local and Hard Currency in Your Portfolio
A fully diversified portfolio can include not only various non-correlated asset classes, but variety within those classes. Exclusively holding hard currency or local currency could mean that you're missing out on the advantages of both; granted, both have unique drawbacks, but a cautious and well-considered allocation in local and hard currencies can provide a favorable balance of risk and reward in just about any sophisticated investor's portfolio.
Ultimately, the value of any currency is predicated on trust in the issuing government. Breach of that trust is a concern for currency investors, which raises the question of whether local or hard currency poses a greater sovereign default risk. While there's no definitive answer to this, the long-standing conventional view is that local currency is safer simply because local governments can easily raise taxes and issue more currency units.
Researchers from the Bank of International Settlements, however, found little to no documented evidence that local governments' perceived creditworthiness actually makes their currency less prone to default; while we can't predict the future, it appears that the sovereign default-risk gap between local and hard currency has closed in modern times.
It's also possible that investors' fear of sovereign-currency default is based on a confusion: Harvard University's Jesse Schreger and the Federal Reserve Board's Wenxin Du strive to disambiguate between credit risk, or "the risk of outright default and capital controls," and currency risk, or "the risk that the currency depreciates." That leads us to the perfectly reasonable concern regarding government-induced currency devaluation, a problem which can beset both local and hard currencies. However, hard currencies like the U.S. dollar, Japanese yen, and European euro are generally less susceptible to sudden depreciation, making them comparatively less volatile most of the time.
To draw an analogy from the world of equities, one could say that local currencies are to small-cap stocks as hard currencies are to large-cap stocks: it's okay to have both in one's portfolio, but I certainly wouldn't recommend "loading the boat" on local currencies. Local currencies like the Venezuelan bolivar and the Zimbabwean dollar provide historical cautionary tales on how volatility is, over the long run, typically not an investor's ally.
Winning on a Small Scale
If hard currency is usually better as a portfolio de-risking vehicle, then local currency offers a narrow focus that could, with proper due diligence, provide superior returns. Local currencies, as the name implies, are localized: they're generally not as susceptible to the complex influences of international geopolitical events and capital flows. Thus, with local currency you may be better able to isolate a much smaller number of factors impacting the price; in short, local-currency investing may entail fewer variables and, hopefully, less uncertainty.
Please don't misconstrue this as an excuse to conduct less thorough research, as local economies can be just as complex as large ones. As a local-currency investor, you'll need to navigate the various destabilizing factors that small-scale economies may face (war, corruption, under-development, lack of autonomy) - not to mention the ever-present competition from the U.S. dollar as more local economies adopt the greenback as a secondary or even a primary store of value and/or a transactional vehicle.
When combining local and hard currency in your portfolio, you might be fixated on buying but selling your assets is just as important: will it be convenient and cost-efficient to cash out your currency if and when you're ready to liquidate it? Call it "slippage" or simply call it the cost of doing business as a currency investor, but you'll need to brace for friction as the cost of exchanging local for hard currency, or vice versa, can be costly.
Consequently, you'll want to consider the value of hard and local currencies relative to the currency that's local to you: a "buy low, sell high" strategy won't work too well if you'll only end up cashing out at a very unfavorable rate. Thus, like it or not, you'll need to study your own government's and central bank's words and actions just as much as those of your target nations in your quest to identify, research, and allocate towards that "perfect" currency-market investment avenue (which, by the way, doesn't exist in the messy world of investing).
A Real Balancing Act
Blending local and hard currency means understanding a lot of moving parts: the dynamics between local economies, multinational capital flows, and an ever complex tapestry of geopolitical concerns. By weighing in favor of less volatile hard currencies, while concurrently taking measured positions in carefully vetted local currencies, investors can thread the currency-trading needle and strike a sustainably profitable balance.
For more insights, join us at the second annual Fixed Income Leaders Summit: Emerging Markets this March 09 - 11, 2020 at the The Ritz-Carlton Westchester, White Plains, NY.
For full conference details, download the 2020 agenda here.